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Changes to Tax on Termination Payments from 6 April 2011

Employers should take care that termination payments are taxed correctly because HMRC can recover unpaid tax, national insurance contributions, penalties and interest from them. Sometimes, for example under the terms of a compromise agreement, the employer will have the benefit of an indemnity from a former employee in respect of any further liabilities, but those will only be as good as the former employee’s ability to pay, and the potential hassle of enforcing an indemnity, and otherwise getting on the wrong side of HMRC, is best avoided.

The first £30,000 of non-contractual payments and also contractual redundancy payments (but not any payment in connection with retirement other than from an approved pension scheme within HMRC limits) made to an employee as a result of the termination of his employment is tax-free. The employee will pay income tax (but not national insurance contributions) on the amount over £30,000. At present, if a termination payment is made after the issue of the P45, employers can deduct only basic rate tax and leave the employee to account for any higher or additional rate tax in a tax self-assessment, which can be up to 21 months later. This is good for employees as they can take the benefit of the additional cash for longer, which they could invest etc.

However, HMRC has announced that there will be changes from 6 April 2011 that mean all of a termination payment above £30,000 will have to be taxed at the employee’s rate of tax at that time. If higher or additional rate tax is deducted from the termination payment but, for example, he does not work again during that same tax year, he will have to claim the overpayment back from HMRC.

HMRC has indicated that further guidance will be issued this month, so watch this space. However, in the meantime employers are advised to amend any compromise agreements which refer to the deduction of basic rate tax only and if further advice is needed in this regard, they should contact Lanyon Bowdler’s employment team.